Internal Rate of Return (”IRR”) is considered to be the best practice of investment performance monitoring. Accurate IRRs can only be computed when all investments and assets have been realized and the cash has been paid back, after the deduction of related charges. This is the net (’cash-on-cash’) return on the wholly realized investment.
However, users of financial information need interim best practice reporting of returns, on a regular basis, before full realization.
Performance can be measured at three levels of IRR:
The gross return on all investments which takes account of all of:
• all the cash outflows (investments) and inflows (divestments, including realization values, interest and dividends, repayments of principal of loans, etc.);
• the valuation of the unrealized investments (consisting of wholly unrealized investments or assets and the unrealized portions of those partially realized).
The gross return on realized and unrealized investments
• For realized investments, the return takes account of all the cash outflows (investments) and inflows (divestments, including realization values, interest and dividends, repayments of the principal of loans,
etc.) which take place between the fund and its realized investments.
For partially realized investments, cash outflows should be allocated between realized and unrealized on a pro rata basis at the dates of each cash outflow.
• For unrealized investments, the return takes account of all the cash outflows (investments) and inflows (interest and dividends) to the extent they refer to the unrealized portfolio, and the valuation of the unrealized portfolio. Partial write-offs or write-downs should be included at this level.
The net return to the investor takes account of:
• the cash flows which take place between the fund and the investors, net, by definition, of all of the fees incurred, remuneration, incentives, brokerage fees and all other applicable professional and ancillary charges which are paid out in the course of investing, managing and divesting;
• the valuation of the unrealized portfolio, made in compliance with valuation best practices (consisting of the unrealized portions of partially realized investments, wholly unrealized investments and also including cash and other assets), after deducting the implied carried interest. When the investments are fully realized/ fully distributed, the net return is the ‘cash-on-cash’ return.